Tuesday, June 9, 2009

Buying to hedge against inflation?

I've had a few emails asking if buying is a smart hedge against inflation. Their thinking is that if inflation takes off, like many think it will, that will drive prices up. And it eventually will. But during the inflationary period home prices are more likely to go down.

Here's my 2 cents. If you are buying for the VERY long haul in an area where prices are close to the long term trends you should be fine. With today's current low rates, a fixed rate loan can get you a nice comfortable payment. I would not stretch to buy right now. If inflation does take off your monthly expenses would shoot up, so you want a nice cushion. The cost of food, clothing, gas, utilities and nearly everything else is likely to rise significantly over then next decade. Don't worry about that $4 a gallon gas, you'll forget about that when it's $10 a gallon. Sure wages will increase too, but wages lag. When inflation tapers off then wages will catch up over a few years. If you buy, leave yourself some financial wiggle room for inflation.

The down side is if you need to sell during an inflationary period you are likely to get creamed. If inflation takes off then the interest rates will likely skyrocket. Remember the 70s? Interest rates were in the 15% range (really they were!). How much can people afford at 15%? Do you think you could sell a $400k home in the IE if the rates were 15%? The principal and interest alone would be over $5k per month on that note. That pretty much eliminates all buyers making less than $200k a year. High interest rates will either tank prices or tank sales (or more likely both).

Is a house a good hedge against inflation? In my humble opinion, only if you stay in it and can easily afford the payments. It's certainly a good hedge against rising rents!


Tyrone said...

There's another thing to worry about during this inflationay/deflationary/hellish period. Remember Obama's Economic team estimating unemployment, with stimulus and w/o it?

HERE is the reality overlayed on the estimates.

You may as well read Denninger's take on it:

golfer_X said...

Nice chart. The really funny (or scary or sad) thing is the so called "stress test" worst case scenario was based on unemployment numbers that we've already blown way past. That whole fiasco was a smoke screen to pump up JSPs confidence in the banks. Obviously it's working but for how long. The great black hope's approval rating is already starting to melt away. Are they catching on?? I doubt it.

el bee said...

"The principal and interest alone would be over $5k per month on that note. That pretty much eliminates all buyers making less than $200k a year."

Wow, that really puts it into perspective.

I'm Not POTUS said...

Inflation the way most people understand it requires one very important thing.
Wage Inflation.
Someone explain how that will happen in America?
Unless the government nationalizes every job, that will be very difficult to achieve. Although by the looks of things they are trying to do this.

If I can't get paid more I have to make do with what money I have. If costs for food and fuel go up and up then I have to cut back on other things.
I can skimp up to a point where I have no more places to cut back. If food and fuel go up at that point I have to cut back on fixed costs.
At this point even more jobs are lost because consumption falls.
If I have to spend every spare penny on food and fuel I will look for cheaper housing accommodations.

It is at this point the people realize there is a difference between assets and expenses.

The value of housing falls because fewer people earn wages and the constant increases in the cost of consumables pushes more people to liquidate assets to cover expense.
More homes are lost, the cost of borrowing rises.

This is a death spiral for assets like homes, stocks, even gold.

Unless people can get paid more to keep up with inflating consumption costs you can't get inflated housing values.

Anyone wondering how energy can cost more with falling demand, has to ask themselves if demand falls off the cliff for oil, will anyone be able to borrow money to drill for it or would they spend cash to drill it and give it away for less than they spent to retrieve it?

I don't think that will happen.

The longer they put off the day of reckoning the more likely it will end up being that you can buy homes for the cash in your pocket.

It happened in the "Great Depression" it most certainly will in the "Greatest Depression"

golfer_X said...

Inflation usually does affect wages too. The problem is that wage increases lag behind price increases. And usually lag behind by quite a long way.

I'm Not POTUS said...

Even in the rosy times of the last 10 years real wages fell. If they can't rise when times are great, how do they go up when it is lousy?

Unions can't force them up. The government is never going to correct the huge gap disparity in pay between the CEO's and their workers.

We don't have enough people nor industry involved in providing basic necessities. All we have is an abundance of frivolous service sectors.

It is going to be a very long long long time before wages catch up.

Christina said...

I think we will see inflation in things that the stimulus has tried to inflate. I am hearing about the craziness in bonded construction (govt projects) that has me concerned. Projects are getting underbid by half from multiple bidders. Somethings that rarely happens. So what are they going to do? Bids always go to the lowest bidder. Are they going to give it to the contractors who underbid it so far the can't cover required materal!? It will bankrupt these companies if they do. And they will need to go to the bond (insurance) company get the work done. It could be a repeat of the housing crisis and AIG insurance.

Don't know if some of you have been following the volitile tick up in rates from the mid 4's into the 5's and the buzz its creating. Possibly causing 60% of the loans in the pipes not go through. Really shows how the Fed has no control over real interest rates.

Diana Olick:


I'm Not POTUS said...

I am one of those contractors who tries to bid public contracts.

Any attempt to turn in a price that covers the cost of labor, materials, equipment and overhead, has been a losing bid for months.

An attempt to turn in a price that covers labor and materials only might improve your odds of getting a job to 1 in 4.

I don't know where these maniacs can come up with the money to do the work. I assume the TARPed banks are leaving credit lines wide open. If they don't do this, the giant insurance companies would have to pay to complete the jobs or default the bonds that insure these public projects.

I no longer compete with the regular crowd of contractors that have done public works exclusively for decades. I have to compete with contractors pushed out of all the others lines of work.

The same thing happened in the tech bubble. Every out of work fiber optic installer low balled water, sewer and gas projects at half price. This time it is former home builders, office builders, warehouse, industrial, petrochemical and out of state firms.

But this time I expect these fools will be bailed out.

Oldtimer said...

There are two aspects to real estate being a hedge against rising inflation. Asset values and debt values. People often forget the debt aspect.

The asset value is pretty simple. Assume that you paid $375K for a home today, and over the next 10 years, inflation averaged 7% (prices would double). If $375K was close to replacement cost today, then replacement cost in 10 years would be $750K. Replacement costs aren't a perfect proxy for values now or 10 years hence, but what is?

The debt value aspect is a little less obvious, but also nearly as important. Gas is running around $3/gallon in my neighborhood. Assume you borrowed $300K to buy the house (80%), and after 10 years of amortization, you still owed $270K (90% of the original loan). You essentially borrowed 100,000 gallons of gas today, and after 10 years you would owe 45,000 gallons of gas at $6/gallon.

In theory, a leveraged asset like a home can be a terrific hedge against rising inflation, but there are some important caveats.

Will your real earnings power keep pace with inflation (will you be able to afford as much gas in 10 years as you can today)? Depends on your line of work.

Will your home's value stay at or above replacement cost? In CA, they have for over 100 years, but not so in Detroit, Cleveland and Buffalo. Who knows if CA will still be attracting new residents in 10 years.

This whole theoretical hedge can get wiped out if you can't afford your payments in the interim. Fix your interest rate, take on a payment you can easily afford, save more than you earn, hope for good health, etc.

Christina said...

Sounds like you are surviving! My thinking is "they know better than to venture down that road" and give it to the companies who underbid like that! Some will anyways, I am sure. Bailout? I don't think so! Its causing a bad taste in most peoples mouth. It won't be around when the effects of this next bubble happen.

All I know is 15% interest rates doesnt sustain prices in $400,000's. House prices will go back to the 1980's levels.

Here is a great chart that shows the change in payment that happen with the increase in interest rates:


here is the guys blog:

Money Talk said...

Debt is being destroyed at a pace that is much greater than the FED printing money. FED is trying to push credit. Banks do not want to lend, borrowers do not want to borrow. Consumers do not want to spend. For inflation to happen all of this must reverse. What is happening is that by foreclosures, bankruptcies, and paying off debt, the bank credit money is being destroyed. Money is created when you take out a loan. When you pay it back, it dissapears. This is why FED has to keep pushing credit or the money expansion stops and deflation occurs. Prepare for MAJOR deflation:


It is going to dwarf Great Depression. Since most of the world's debt is nominated in US dollars, when debt is destroyed, US dollar supply is reduced. Even though it is a sick currency, it's value goes up in a deflationary crash. If FED prints too much money, which they can do due to panic at the bottom of deflation, Inflation will occur AFTER the deflation. You can buy your gold then, there is no hurry. This is why Gold, Silver is not going anywhere even though financial system is butchered and FED makes money available. What FED is doing right now is not enough for inflation yet.